Three reasons to remain cautious about the euro

With so much focus on Brexit and Trump’s threats against China, it has been easy to overlook key influences for the euro in recent weeks. The single currency has been trapped in a relatively well-defined range against the Greenback in recent months ($1.12 – $1.18) but experience tells us not to become complacent in this environment.

With this in mind, we take a closer look at three key factors that in our minds, warrant caution for the euro and reinforce the bearish stance that we’ve maintained in recent years.

ECB Monetary Policy:

Back in 2012, at the height on the Eurozone debt crisis, Draghi pledged to do “whatever it takes” was enough to bring calm to the markets and stave of a run on Europe’s largest banks. Six years on, while many of the world’s central banks are attempting to normalise monetary policy (whatever that has come to mean) the ECB still has negative deposit rates and a huge balance sheet.

A quick glace at the chart below shows an alarming difference between the balance sheet of the Fed and that of the ECB. As the US economy grows, the Fed has begun slowly shrinking its holdings and consequently, the Fed’s assets as a percentage of GDP is slowly falling. In contrast, the ECB’s balance sheet (as a percentage of GDP) increased dramatically throughout 2014/2015 and while its been relatively steady in 2018, it is still twice the size of that of the Fed.

The correlation between the size of a Central Bank’s balance sheet and the strength of its currency is far from perfect – Japan is a good example of this. The Yen is exactly where is was against the dollar four years ago despite the BoJ’s balance sheet increasing from 58% of GDP in November 2014 to 102% at the end of November 2018. There are some notable differences between the assets held by the BoJ and those held by the ECB, but it seems safe to say, the growth in the ECB’s balance sheet is unlikely to have a positive impact on the euro.

European Banking Sector:

The former head of the European Banking Authority, Andrea Enria, has today issued a warning that the EU’s stress tests that are meant to test whether a bank has enough capital to weather another storm, are not stringent enough. Since EU authorities began running these tests in 2011, banks have strengthened their capital buffers and as a result, the tests have either given them a clean bill of health or at worst, suggested minor remedial action. However, banks have still found themselves in difficulty soon after suggesting that the tests are not demanding enough to provide the necessary warning signals.

There appears to be three main problems. Firstly, the tests rely on the banks’ own models to determine whether they have sufficient capital and are hence subject to manipulation to help achieve the desired outcome. While the Fed’s tests have also been criticised for being too soft, they do at least require all banks to use the same model and therefore facilitate a fair comparison. Secondly, European regulators do not share either the results of the tests or the details of any remedial action required. Adding transparency here will also help make the tests more rigorous. Finally, the EU authorities have been criticised for not imposing harsher penalties. Whilst nobody wants to see banks going bust, there is a danger that bad loans will continue to sit on balance sheets indefinitely, undermining the credibility of the system and increasing the risk of greater instability in the future.

Politics:

The most grabbing headlines in recent months have related to political uncertainty. Readers in Europe, particularly those in the UK, will have suffered Brexit fatigue of late. The potential adverse impact on the UK economy of a no-deal Brexit has been widely debated since the referendum, but far less has been made of the impact on the Eurozone economy. While we acknowledge that the negative consequences for the UK have the potential to exceed those facing the EU, Britain’s departure is sure to have a negative impact on the wider Eurozone economy too.

Meanwhile, Trump’s protectionist policies are also likely to have negative consequences on the Eurozone. Although German car manufacturers saw their share prices jump this morning after Trump’s talks with China over weekend, it the war on trade is far from over. Aside from China, Trump has his sights firmly set on Europe.

Ultimately, while the points about both ECB monetary policy and politics could be flipped to make a positive argument, supportive of the euro, we continue to see the risks for the euro being negative, particularly in the short term. Studies suggest that the euro is currently around 10% undervalued against the dollar which while significant, is far from extreme. Meanwhile, speculative positioning has only recently turned negative suggesting that there is still plenty of scope for a further move lower. This ties in with our forecasts of being bearish on the euro in the coming quarters although we do see growing risks of a reversal as we head into the latter stages of 2019.

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